People have different levels of debt. Some people have 10 credit cards, while others have no credit cards at all. Companies are the same way. Some companies have a more aggressive appetite for debt. However, if a company is getting more capital from debt, then it may be taking on too much risk. Likewise, if a company is taking on too much equity, then it may be paying too much for capital. The challenge for companies is striking the right balance between debt and equity. This balance is referred to as a firm's capital structure. Cost of capital is how investors evaluate weighted average cost of capital (WACC). While Target Corporation (NYSE: TGT) struggled in 2015, its capital structure appears to be in line with its peers.
Capital: Debt vs. Equity
There are two forms of capital for a business: debt and equity. These are the two ways that companies raise money when in need of cash to fund business operations. Debt refers to capital financed with bonds or loans. Companies generally must pay interest on debt, and this interest level is used to determine the cost of debt. The cost of debt is actually the interest rate at which a company can borrow funds on the present day, not the rate obtained on past debt obligations. It is calculated by multiplying the long-term borrowing rate of the company by one minus the tax rate. Companies can also obtain financing by selling ownership in the company, referred to as equity. The cost of equity is the rate of return required by investors, based on the company’s risk profile.
Both the cost of debt and equity are important to investors because they help investors to understand what to expect in terms of future growth and risk. Companies with higher degrees of debt are considered riskier. Companies do not have to pay back equity in times of crisis, but debt must be paid back regardless of the company’s financial position. At the same time, companies that take on more debt also tend to experience higher rates of growth. The prospect of higher growth compensates investors for the added risk.
Target's Capital Structure Trends
As of April 2016, Target had 603.8 million shares outstanding, down considerably from a peak of 665 million in August 2015. As a result, market capitalization was down from $44.4 billion to $39.4 billion, after reaching a peak of $54.3 billion in August 2015. Short-term debt increased significantly as well, from $91 million in January 2015 to $1627 million in April 2016. However, cash has nearly doubled from $2.2 billion to $4.0 billion. Long-term debt was flat at $12.6 billion, along with total debt, which dropped slightly from $12.796 billion in January 2015 to $14.223 billion in April 2016.
Enterprise value (EV) is a measure of a company’s capital structure. It is calculated as market capitalization plus debt, minority interest and preferred shares, minus total cash and cash equivalents. The EV is often used with a measure of earnings to provide a relative value, and may be more useful when comparing firms operating under a large amount of debt. EV is also considered a better measure to use by acquirers since it includes both debt and cash. In January 2015, EV at Target was $59.229 billion and fell to $52.88 billion in April 2016, after peaking in August 2015.
Capital structure ratios help investors gauge the level of risk that a company is taking on through financing. Both the debt-to-market equity ratio and the enterprise value show that while Target's short-term debt has gone up and market capitalization has gone down, the company's capital structure is aligned with the rest of the industry.